A great deal of attention is on gas at the moment, but big opportunities are in oil as its price moves well beyond pre-pandemic levels, towards US$100/barrel because of cuts to investment in future oil supply. We look at why existing producers and smaller oil producers, in particular, are in the box seat.

Read more about Investing in Small Caps. Why we picked these ASX Small Cap gems and their outstanding performance.

Near-Term Oil Production Recovery

The graphic clearly shows the oil price is rising and one reason is increasing demand, as economic growth rebounds in the big economies of Asia, the US, and Europe. Total average oil consumption in 2019 was just over 100m barrels/day. This fell to 92m barrels/day in 2020 due to the pandemic. Consumption has recovered to over 97m barrels/ day in 2021 with most observers expecting consumption to exceed pre-pandemic levels to 101.5m barrels/day in 2022.

Big Recovery in Oil Prices

The oil price has recovered strongly from a low of US$35/ barrel* in November 2020 to a current level of well over US$80/bbl. However, for much of 2021, the share prices of many oil stocks, including Australian stocks such as Santos (ASX:STO) and Woodside Petroleum (ASX:WPL), have been in decline. This has been very frustrating for the investor. Is there an explanation?

Underperformance in Larger Oil Stocks to be Expected

Our view is that the poor performance of many oil stocks, especially the larger ones, is to be expected. Valuations for oil stocks are normally based on a discounted cash flow analysis which values the company on the sum of the valuations for individual projects.

Weaker longer-term prospects driving down valuations

In a world moving to net zero emissions, many medium-term and long-term oil projects, which may involve capital expenditure in the billions, are less likely to go ahead. Woodside’s Browse project, which is actually a liquified natural gas (LNG) project is an example. This automatically lops off future cash flows which are part of the valuation.

Maintaining Oil flows requires continuous Investment

Further, oil flows are strongest when the oil well starts production. Soon, the flow rate drops, with 10% per year being typical, as natural pressures driving the flow decline. An oil field requires continuous investment to develop new wells to replace declining wells and new satellite projects to replace depleting fields. To keep the ball rolling, ongoing exploration is required to prove up oil resources for the future. With rising uncertainty on demand, prices, availability of funding, and the timeline of future cash flows, the probability factors that are used in valuation calculations are cut.

Smaller Oil and Gas companies have better certainty

These factors are less likely to affect smaller companies in the oil and gas sector such as the Under the Radar Report's picks in this week's Blue Chip Report, where there are specific projects being developed with a relatively high degree of certainty. Another way to take advantage of the strengthening oil price is to buy the energy sector contractor, Worley (ASX:WOR), which we cover in Blue Chip report issue 89, page 10. This represents a lower risk because its profits are more consistent, being based on the spending of oil producers, as well as the emerging megatrend in global sustainability.

Production Uncertainty Expected to be good for Oil prices

Small companies are likely to be beneficiaries of the uncertainty. We believe oil prices are higher today than they would otherwise be because of the expected drop in future oil-related investment. This view is supported by the industry. BP, for instance, has increased its price forecasts for benchmark Brent crude oil to 2030, which it justifies by citing expected supply constraints. However, it has lowered its longer-term price forecast because it expects an acceleration in the transition to renewable energy. We believe oil prices will continue to move higher, and could quite get to US$100/barrel.

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